Over the hedge

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Since the collapse of Bernard Madoff's US$50 billion Ponzi scheme in December 2008, which showcased the risks of these complex, opaque trading vehicles, there has been a slew of further scandals.

Next month, Galleon Group founder Raj Rajaratnam, whose fund once controlled US$7 billion, begins an 11-year prison sentence in the US for insider trading.

Last month the US Securities and Exchange Commission accused hedge fund manager Andrey Hicks of duping wealthy individuals out of US$1.7 million by setting up a purported hedge fund that he claimed used 'quantitative strategies [that] were based on mathematical models he developed while at Harvard'. But, the SEC alleged, Hicks was a Harvard dropout who diverted clients' money for his own use.

Hedge funds, privately owned trading vehicles that punt on everything from stocks to sugar cane, are not performing well.

Globally, they have posted a negative 8 per cent return so far this year, according to industry data compiler Hedge Fund Research. Asia-Pacific funds have done worse, falling over 10 per cent.

US market researcher Preqin just reported that dissatisfaction with hedge funds is at a four-year high. Forty per cent of investors said returns were below expectations, and 43 per cent complained managers' fees were too high.

But we can't dismiss hedge funds as a bad investment without looking at what they try to do, how well they have done and whether they are worth their high fees.

Industry data claims hedge funds have provided far superior returns to equities historically. Some studies have questioned this data, others have claimed returns could be replicated by a computerised trading system.

Hong Kong's Securities and Futures Commission stipulates that only professional investors - people with a portfolio worth at least HK$8 million -may use hedge funds.

Even for those rich enough to buy in, it is hard to identify the funds that will at least give an industry-average performance.

According to Hedge Fund Research, hedge funds have returned a cumulative 953 per cent since 1990 - which looks fantastic compared with the 80 per cent gain in the MSCI index of world stocks during the same period. The hedge funds achieved this feat while giving their investors a smooth ride, displaying 7 per cent annualised volatility, compared with 15 per cent for stocks, Hedge Fund Research's figures show.

Managers typically charge 2 per cent of assets under management. If the returns were better than those achieved a year previously, the managers also pocket a fifth of the funds' profits. The well-known shorthand for this is 'two and 20', or 2 per cent management fee and 20 per cent performance fee.

He says that, as part of a balanced portfolio, these vehicles provide shelter from stock market storms because their traders aim to generate returns that are not driven by equity market movements.

'The basic idea is non-correlation [with stocks]. Hedge funds help investors not to put all their eggs in one basket,' says Jones.

Ben Yearsley, head of investments at Hargreaves Lansdown, is a doubter. He says it is hard to isolate the best managers from frauds, and questions the accuracy of hedge fund industry data.

'Databases of hedge fund performance seem unreliable. There is not enough evidence to say hedge funds, collectively, are brilliant or bad. Most investors go in blind.

'I am often mystified by how very wealthy people will pay the 'two and 20' for hedge funds. I put it down to a sort of golf-club mentality, in that using hedge funds is a status symbol for the very rich,' he says.

The basic premise of hedge funds is, however, remarkably sensible.

Back in 1949, US-based, Australian- born sociologist and financial journalist Alfred Winslow Jones launched the best-known early hedge fund. He realised that by buying some stocks and selling some short - betting their price would fall - he could achieve returns unaffected by swings in stock prices.

Thousands of traders have sought to copy his example. Because hedge funds can trade anything with a price, there is no all-round definition of how they operate. They all aim for smooth annual trading gains that strip out the volatility in other investments.

Data provider Eurekahedge states that Asian hedge funds returned an average 8 per cent a year in the three years to last month. Such figures portray hedge funds as safe haven investments whose money grows smoothly over time.

Yet Princeton University professor Burton Malkiel found that published databases of hedge fund returns are misleading. He saw some funds tend to exaggerate how well they did, and bad performers often stop reporting to database compilers.

Malkiel examined the results of defunct hedge funds alongside successful ones, and concluded that, from 1996-2003, hedge funds returned 9.32 per cent on average, against the 13.74 per cent return of funds in the published league tables.

Other academics claim hedge fund returns can be simulated via low-cost trading strategies; that is, the asset class is not worth its fees.

In 2005, Harry Kat of London's Cass Business School developed a formulaic strategy trading S&P 500 stocks, US Treasury bonds and euro-dollars (US dollars on deposit in foreign markets, such as London) that he said replicated four-fifths of hedge fund performance.

'Hedge fund returns have unusual risk characteristics but are not truly superior,' Kat wrote. He added that his strategy could be tweaked to provide what investors look for in a hedge fund - low correlation with assets in their existing portfolio, and a low level of annual volatility.

Hedge funds are inscrutable. Some may be brilliant, and a skilled trader can produce outsized returns. Investment banks do it all the time with their internal trading desks. The problem for individual investors is knowing which hedge funds produce decent returns through clever trading strategies or plain luck. It is also difficult to know whether a fund is ripping them off.

There is one solution to this problem, which are funds of hedge funds, in which professional investors review hedge funds on the behalf of individuals. This has its own set of pros and cons, which will be reviewed in an upcoming column.